Backing the USA: Dollar climbs as investors buy into recovery

Chris Papadopoullos
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The US dollar has climbed against the euro over the past year
Amid much talk of a US rate hike, Chris Papadopoullos asks if it will happen as quickly as some think

The Federal Reserve has a way with words. Last year, it prompted mass market confusion by saying it would wait for a “considerable time” before hiking interest rates.

In December, it ditched the term and said that it would instead be “patient”, a word that Fed chair Janet Yellen later clarified as meaning a rate hike was at least two meetings away. This means the Fed could raise interest rates as early as June if “patient” is removed from its policy statement next week.

“My concern is that in pushing rates up they could be making the same mistake the European Central Bank made in 2008 – they pushed rates higher only to cut them again,” Michael Hewson of CMC Markets told City A.M. “I’m still not convinced that the US economy can handle a rate hike. The job numbers are very positive, but my overriding concern is the lack of inflation.”

The American Labor Dep­art­ment has been releasing a steady stream of strong job figures. US employers had five million job openings at the end of January – the highest level for 14 years, according to data released this week.

Another indicator the Fed watches closely is core inflation – that is, stripped of volatile food and energy prices. It edged down to 1.6 per cent in December and stayed there in January. Another important question is whether a June rate hike will fuel further strengthening in the dollar.

“I think the rise in the dollar so far has priced in a significant rate hike already,” Hewson said. He believes the euro will reach parity with the dollar next month. Other analysts are tipping the dollar to strengthen further. For the US, a stronger dollar will likely mean a change from investment-led to consumer-led growth, according to Charles Dumas of Lombard Street Research (LSR). The strong dollar is reducing import costs. This – and subdued oil prices – is helping to keep inflation low, meaning that workers’ pay packets can buy more goods and services. Consumer spending will be boosted, but investment will be cut by shale frackers, who will be hit by low energy prices.

The effects of a rate hike and stronger dollar have consequences for emerging markets, too. “In­vestors are nervous that currency mismatches could bring about another 1990s-style crisis as the Fed tightens policy,” said economist Shweta Singh of LSR.

Many companies in emerging markets in the 1990s had debts that were owed in dollars. However, their income was in local currency which meant if that if the dollar strengthened against the local currency, there was a risk of a widespread balance sheet crisis.

“[In the 1990s crisis] the trigger for their [emerging markets’] fall from grace was a strengthening dollar amid expectations of tighter policy in the US, a combination which of course applies again now.” However, Singh says “almost all emerging markets appear less vul­nerable today to a strong dollar than prior to their respective crises in the 1990s.” Nonetheless, she warns the most exposed to dollar strength are Turkey, South Africa, Brazil and Indonesia.

Yellen will remain closely watched.

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